Friday, January 18, 2013

Lars Christensen's excellent post about the necessity of having a monetary constitution includes an interesting point about central bank independence:

We want central banks to stop the ad hoc’ism. In fact we don’t even like independent central banks – as we don’t want to give them the opportunity to mess up things.

Central bank independence has become the standard approach to structuring the nexus between government service-provider and central bank liquidity-provider over the last fifty years. I think a degree of independence makes a lot of sense. Running a monopoly clearing house (which is really what a central bank is) while simultaneously operating other businesses and charities (which is what a government does) presents a tremendous conflict of interest.

For instance, imagine that General Electric was granted a monopoly to operate the U.S. clearing system. Wouldn't we worry that GE might use that clearing system to support its appliance or turbine manufacturing businesses? It might, for instance, require that those borrowing clearing balances submit GE securities as collateral but not those of GE's competitors, thereby giving GE an unfair financing advantage. Or why not have the clearing house give GE an interest free loan? Member banks can't leave the clearing house for another—it's a monopoly, after all—so there are no counterbalancing forces to discipline GE should it choose to abuse its clearing house duties.

A government is no less conflicted than GE in running a nation's monopoly clearing house. In recognition of this, we hive off central banks from government by establishing strict central bank acts and operating procedures.

But as Lars points out, we shouldn't make an idol out of central banking. Without a monetary constitution, independent central banks can screw up royally. The German Reichsbank from 1921-1923, which I wrote about in How To Stop a Hyperinflation, is a great example of this.

With prices rising at around 100% a year, Rudolph Havenstein, the President of the Reichsbank, was discounting bills at a mere five percent up until July 1922. By April 1923, Havenstein had increased the discount rate to 18%, and in September to 90%, yet by then prices were doubling every two days. Businessmen only had to take out a loan from the Reichsbank, buy and hold goods, stocks, gold, or US dollars, and when the loan was due, sell whatever had been bought for devalued reichsmarks in order to settle the loan. Even with the loan costing 90% per annum, returns on these assets were so many multiples higher that the profits on this trade were huge.

Havenstein and the board of the Reichsbank had adopted a theory that the mark was depreciating due to external circumstances. According to Laidler (1998), this theory went something like this. An adverse balance of payments (due in part to reparations requirements) was causing the reichsmark to fall in international markets. This resulted in higher local wages and prices, which created a shortage of money. The Reichsbank was only resolving the shortage by passively meeting the demand for credit. Conveniently, this theory absolved the bank's low interest rates of any responsibility for the inflation.

By the fall of 1923 Germans had had enough and voted in a government who promised monetary reform. But the government ran into a problem—they couldn't get control over Havenstein. Hjalmar Schacht notes in his autobiography Confessions of "The Old Wizard" that Havenstein was not on good terms with the government and despite indications that it wished Havenstein to retire, the Reichsbank President had resisted.

Havenstein was able to dig his heels in because in May 1922, the Reichsbank's Autonomy Law had come into effect. This law effectively enshrined the Reichsbank's independence from the government and installed Havenstein for life. Germans were effectively held hostage to a 66-year old independent central banker who refused to acknowledge his responsibility to raise interest rates in order to stop a hyperinflation. Its options limited, the government decided to try hacking around the Reichsbank by creating an entirely new currency, the rentenmark. Schacht was asked to run the bank that issued these notes, the Rentenbank. Liaquat Ahamed explains this unusual situation as it stood in mid-November:

Saddled with Von Havenstein, Stresemann had simply bypassed him by creating the independent Currency Commissionership outside of the Reichsbank [to manage the Rentenbank]. And so, when the new currency was introduced on November 15, 1923, Germany found itself in the curious position of having two official currencies—the old Reichsmark and the new Rentenmark—circulating side by side, issued by two uniquely parallel central banks. At one end of town was Schacht, operating from his converted broom closet; at the other, Von Havenstein, holed up and increasingly isolated and irrelevant in the Reichsbank’s imposing red sandstone building on Jagerstrasse. Although the Reichsbank had now stopped providing money to the government, its printing presses still continued to roll out trillions of Reichsmarks to private businesses. (Lords of Finance, Chapter 10)

As I wrote in my previous article, what stopped the reichsmark inflation cold by the end of November 1923 was not the debut of Schacht's rentenmarks on November 15 but an abrupt change in the Reichsbank's policy. This rapid reversal could only happen because of the sickness and sudden death of Havenstein on November 20th from a heart attack. Hjalmar Schacht immediately exerted his presence. He ceased the Reichsbank's acceptance of notgeld and tightened credit, thereby halting the mark's slide by the end of November, a week after Havenstein's death.

The point of this story is that independent central banking is not a panacea. Yes, it's probably a good idea to set limits in order to minimize the potential for conflicts of interest between government and the monopoly clearing house. But if an independent central banker is left to follow whatever ad hoc rule (or lack thereof), the consequences can be disastrous. A monetary constitution of the sort that Lars describes is one way to solve this problem. Even better is to open up the clearing house business to competition and choice. That way irresponsible central bankers can be disciplined by the same forces that discipline irresponsible grocers, farmers, salesman, and the rest of us great unwashed—just cease doing business with them.

2 comments:

Great article. Monetary textbooks never tell the story as fully as you did. And thank you for not joining the usual chorus blaming the hyperinflation on the bank's supposed adherence to a policy of only issuing new money in the discount of real bills. When the market interest rate is 100%, a bank discounting bills at 5% is not adhering to the real bills doctrine.

I did run into that criticism of Havenstein while doing the research. I think the criticism only sticks to an extremely naive real bills doctrine, but not the backing theory that you've outlined on your website. Whether Havenstein actually held to a naive version of the RBD is tough to verify.